Retained Earnings Don't Match Last Year's Return: The Fix

Why don't my retained earnings match last year's return?

Retained earnings or owner's equity in this year's books should open at the figure last year's books closed with, and the balance sheet on the filed return was meant to come from those books. Retained earnings is the profit the business has kept after distributions. Schedule L is the balance sheet on a business return; the instructions for Form 1120-S, Form 1120 and Form 1065 all say it should agree with the books and records.

When the two differ, the usual cause is that the books changed after the return was built, or that the return was built from entries the owner's books never held, such as a preparer's year-end adjustments.

Equity is assets minus liabilities; Publication 583 calls it net worth. That tells you where to look:

• Total equity differs. An asset or liability balance differs, because an entry was posted in one set of books but not the other, or a closed year was edited.
• Total equity matches but its parts do not. Money sits in the wrong account, such as a draw booked as an expense or an owner's deposit booked as income.

The case is not simple when the gap has more than one cause, reaches back more than one year, the preparer's entries cannot be found, the cause changes income or deductions on a filed return, a lender or buyer needs the books to tie to the return, or the IRS has written about the return.

Gather before you start:

• Last year's filed return, with Schedules L, M-1 and M-2 where it has them.
• The preparer's adjusted trial balance (every account balance after year-end entries) and year-end journal entries.
• This year's opening balance sheet and last year's general ledger.
• Year-end bank, card and loan statements.
• Records of owner draws or distributions.

Should this year's opening balance equal last year's ending balance?

Yes. Balance sheet accounts carry forward unchanged; only profit and loss restarts. Publication 583 says a double-entry system closes income and expense accounts at the end of each tax year, while asset, liability and net worth accounts stay open permanently.

The forms expect the same. The Form 1065 instructions say beginning total assets must generally equal the prior year's ending total assets, with a statement explaining any difference. Schedule C asks for an explanation when beginning inventory differs from last year's closing inventory.

A difference between book income and taxable income is not by itself a reason for the books to differ from Schedule L: Schedule M-1 reconciles income per books with income per return.

Where is retained earnings on the return's balance sheet, and which number do I compare?

Compare the end-of-year column of Schedule L, the balance sheet per books, where retained earnings or capital appears. The line depends on the entity.

A single-member LLC that elected to be taxed as a corporation files a corporate return, so use the S corporation or C corporation row (Schedule C instructions).

A small entity that answers Yes to the Schedule L skip question on its return may have no balance sheet to match; use last year's closing report from the books. Who qualifies: Schedule L on a corporate return.

Is an S corporation's accumulated adjustments account the same as retained earnings?

No. The accumulated adjustments account (AAA) on Form 1120-S Schedule M-2 is a tax account. The instructions say it generally reflects accumulated undistributed net income and is zero on the first day of the first S year. It is used to work out the tax effect of distributions, and the instructions recommend that every S corporation keep it.

Retained earnings on Schedule L, line 24, is a books figure that follows the books, not the election date. The two can legitimately differ, so a difference between them is not by itself an error. Why they differ and how to check: S corporation balance sheet not balancing. Booking distributions so that Schedule L stays right: S corporation distributions.

What causes the gap?

An entry is in one set of books but not the other, or money landed in the wrong account. The table pairs each cause with what shows and where to look.

How do I find the gap, account by account?

Compare last year's balance sheet from the filed return with the same date in today's books, line by line, then trace each difference.

1. Get the balances the return was built from: the preparer's adjusted trial balance, or the end-of-year column of Schedule L if that is all there is.
2. Run today's balance sheet as of last year's closing date and group the accounts into Schedule L's lines: cash, receivables, inventory, depreciable assets less accumulated depreciation, payables, loans and equity.
3. List every line that differs and by how much. The asset differences less the liability differences must equal the equity gap. If they do not, a line is still hiding.
4. Compare last year's profit in today's books with net income per books on last year's Schedule M-1, line 1, where the return has one. Unequal profit means last year's income statement differs from the one the return used: an income or expense entry was added, changed or never posted. Equal profit does not rule out offsetting errors, such as an owner loan booked as income and a draw booked as expense: check the detailed income and expense accounts as well as equity entries and earlier years, starting with the beginning-of-year column of last year's Schedule L against the books for that date. A gap there began before last year.
5. Open the ledger for each differing account in the closed year. Use the books' change history or audit log, if it keeps one, to list entries dated last year but entered after the filing date, and look for preparer entries that never arrived.

If the books were started by typing in opening balances, check that entry too: opening balances after changing accountants.

How do I roll retained earnings forward?

Closing retained earnings equal the opening balance, plus net income per books, less distributions, plus or minus other itemized changes. Form 1120's Schedule M-2 is built this way, from beginning balance to ending balance, and ties to Schedule L, line 25 (form).

Other entities roll forward the same way on their own equity accounts. A partnership tracks each partner: beginning capital, plus contributions, plus share of net income, less distributions. A sole proprietor tracks one owner's equity account, with draws kept in the drawing account. An S corporation's Schedule M-2 is the AAA, not this roll-forward, so keep your own schedule.

If rolling forward from last year's closing gives a different opening than the books show, the difference is the gap.

How do I correct the books without editing last year?

A common way to keep the filed year intact is a correcting entry dated the first day of the current year, not a change inside the closed year. The closed year is what the filed return was built from. Editing it makes the books disagree with a filed return and moves last year's profit with no trace.

1. Write one entry per differing balance sheet line. The other side goes to retained earnings for a corporation, to owner's equity for a sole proprietor, and to each partner's capital account for a partnership, split to match the filed capital. Your preparer confirms the account.
2. Date it the first day of this year and describe the source, for example "preparer's year-end entries per adjusted trial balance". Keep the support.
3. Keep income and expense accounts out of the entry when the return already includes the item. Otherwise this year's profit absorbs last year's cost.
4. Record later payments against the liability the entry created, not as a new expense, or the cost counts twice.
5. Re-run the opening balance sheet. It should equal the filed Schedule L, or each remaining difference should be listed with a reason.
6. Lock the year: closing date after taxes are filed.

The Form 1120-S, 1120 and 1065 instructions do not set a date or account for this entry; it is a bookkeeping practice that keeps the filed year intact.

When does a difference mean the return itself needs amending?

The return may be wrong when the gap includes an income or expense item that changes the closed year's income. When the gap is only balance sheet items the return already reflects, its income and deductions are unaffected and the books are what get fixed.

If the preparer is no longer available, another CPA or enrolled agent can compare the filed return with the books and say whether an amended return is needed.

If the return does need correcting, an S corporation files an amended Form 1120-S, a C corporation files Form 1120-X, and a sole proprietor files Form 1040-X (amending for business expense mistakes). A partnership subject to the centralized partnership audit rules (years beginning after 2017) generally files an administrative adjustment request (AAR), signed by its partnership representative; one that is not subject files an amended Form 1065 (Form 1120-S and Form 1065 instructions). A partnership is subject unless it elected out on that year's timely filed return. Only a partnership required to furnish 100 or fewer Schedules K-1 can elect out, counting each shareholder of an S corporation partner, and only if every partner is eligible (individuals, C corporations, S corporations, estates of deceased partners and certain foreign corporations) (IRS: electing out).

An amended Form 1120-S or 1065 comes with amended Schedules K-1 for any owner whose K-1 figures change, and owners may then need to amend their own returns. An AAR does not: adjustments passed to partners go on Form 8986, and the partnership pays any imputed underpayment with the AAR unless it elects to push all adjustments out to its partners (IRS: AAR filing). An AAR is generally due within 3 years of the later of the filing date or the unextended due date, and generally not after the IRS issues a notice of administrative proceeding (same page). A refund claim on Form 1120-X or 1040-X is generally due within 3 years after filing the original return or 2 years after paying the tax, whichever is later (Form 1120-X and Form 1040-X instructions). Owners' own returns and the rest: correcting a filed business return.

Running a prior year's income or expense through this year's profit puts the item in the wrong year; ask the preparer how an item missing from a filed year should be handled.

Does changing my year-end or accounting method change retained earnings for earlier years?

Not on returns already filed: earlier years stay as filed. The books can still open differently after a change.

• Year-end. A new tax year creates a short tax year, running from the day after the old year closes to the day before the new year begins (Publication 538). Retained earnings roll through it like any other period. Partnerships and S corporations generally must use a required tax year, so a different year-end is often not available (Publication 538). Choosing a year-end: fiscal year or calendar year.
• Accounting method. Changing the return from cash to accrual needs IRS approval (Publication 538) and is requested on Form 3115, not an amended return (Form 1120-X instructions). A C corporation, or a partnership with a C corporation partner, must make the change once its 3-year average gross receipts pass $32,000,000; farming businesses and qualified personal service corporations are excepted (section 448). An automatic request goes with the timely filed return for the year of change, extensions included, and the section 481(a) catch-up adjustment starts in that year, not in earlier years (Form 3115 instructions). Keeping accrual books while the return stays on cash does not by itself change the return's method, but the records must reconcile the books to the return (Reg. 1.446-1). Either way, converting cash books to accrual adds receivables and payables to the opening balance sheet, so opening equity can move by the difference. Method change: switching from cash to accrual.

Correcting a math or posting error is not a change in accounting method (Publication 538). An item treated the same wrong way on past returns, such as depreciation never taken on two or more consecutive returns, can be a method question: ask the preparer before correcting it.

Example

These examples are illustrative. All figures are in US dollars.

S corporation: the preparer's year-end entries never reached the owner's books

The filed Schedule L, line 24, shows retained earnings of US$61,000 at year-end. This year's books open at US$84,000, a gap of US$23,000. Assume the corporation uses the accrual method. The preparer had posted US$15,000 of depreciation and US$8,000 of accrued expenses that the owner's books never received. Assume both entries belong to last year, so the books and the return agreed at its start and book profit for last year is US$23,000 higher than Schedule M-1, line 1.

Run last year's balance sheet and the differences appear: accumulated depreciation is US$15,000 lower in the books, and accrued liabilities are US$8,000 lower. Together they equal the gap. The return was right, so only the books change. The entry, dated the first day of this year: debit retained earnings US$23,000, credit accumulated depreciation US$15,000, credit accrued expenses US$8,000. The books now open at US$61,000. When the US$8,000 is paid, it settles the liability instead of becoming a new expense.

Single-member LLC on Schedule C: no return line to match

Schedule C has no balance sheet. The closing report saved last year shows assets of US$30,000 and liabilities of US$12,000, so owner's equity of US$18,000. Today's books show last year-end equity of US$15,000.

Assume the LLC uses the cash method for books and tax and the supplies were used up in the month they were bought, so they belong to the year they were paid (Publication 538). The ledger shows a US$3,000 supplies payment, entered in March with a December date. If the payment record shows January, the entry was wrongly added to the closed year after filing: move it to its true date and equity returns to US$18,000. If it shows December, the books are now right and the filed Schedule C may have left out a deduction; whether to amend is a question for amending for business expense mistakes.

Two-member LLC taxed as a partnership: the total matches, the split does not

The books are kept on the tax basis. Schedule K-1 item L shows ending capital of US$70,000 for Partner A and US$70,000 for Partner B, which equals Schedule L, line 21, of US$140,000. The books also total US$140,000 but show A at US$77,500 and B at US$62,500.

Partner A's US$15,000 draw was booked as an expense, but the return shows it as a distribution. With profit shared equally, each partner's capital fell US$7,500 instead of A's falling US$15,000. The fix is one entry on the first day of this year: debit A's capital US$7,500, credit B's capital US$7,500. The total does not move. Had the return also deducted the draw as an expense, its capital figures would match the books, its income may be too low, and it may need amending, unless the payment was really a guaranteed payment, which is set without regard to the partnership's income and deducted on Form 1065, line 10 (Form 1065 instructions).

Different for you?

• The gap has more than one cause, spans several years, the preparer's entries cannot be found, a lender or buyer wants the books to tie to the return, or the IRS has written about the return: the books may need rebuilding from the filed returns and statements, and someone has to decide whether one correcting entry is enough and whether any return needs amending. See bookkeeping when the books and the return disagree.
• You changed accountants or software and have only last year's reports: see opening balances after changing accountants.
• A large or negative Opening Balance Equity account: see Opening Balance Equity.
• Owner's equity went negative after draws: see negative owner's equity.
• An S corporation's Schedule L will not balance before filing: see the S corporation balance sheet guide.
• A return was wrong and K-1s went out: see correcting a filed business return.
• The LLC changed how it is taxed (for example an S election) or you are setting up LLC equity accounts: see books after an S corporation election and LLC equity accounts.